Thursday 26 April 2012 19.35 EDT
First published on Thursday 26 April 2012 19.35 EDT

Spain's precarious economic situation has worsened after the ratings agency Standard & Poor's downgraded the country's debt and warned that its recession was likely to deepen by the end of the year.

S&P cut the rating on Spain's debt mountain by two notches, from A to BBB+. The downgrade is expected to push up the cost of borrowing immediately, as investors become increasingly worried over Madrid's inability to cut spending without sending its beleaguered economy into a deeper recession.

European leaders have feared that investors, who have watched the unfolding euro crisis over the last two years, would withdraw their support for Spain in response to the increased risk that it will be forced to accept a multi-billion-euro rescue package from Brussels.

S&P said: "The downgrade reflects our view of mounting risks to Spain's net general government debt as a share of GDP in light of the contracting economy, in particular due to the deterioration in the budget deficit trajectory for 2011-2015, in contrast with our previous projections, and the increasing likelihood that the government will need to provide further fiscal support to the banking sector.

"Consequently, we think risks are rising to fiscal performance and flexibility, and to the sovereign debt burden, particularly in light of the increased contingent liabilities that could materialise on the government's balance sheet," it said.

The ratings agency, which has already cut Spain's debt rating once this year, put a negative outlook on the credit with a view to further downgrades if the situation fails to improve. Moody's rates Spain one notch higher at A3 with a negative outlook, and Fitch Ratings has it two notches higher at A, also with a negative outlook.

Spain has rapidly become the weakest link in the eurozone after Italy succeeded in calming fears that it stood on the edge of bankruptcy.

Speculation that several of Spain's banks will need to be rescued is a key concern following the property crash and a dramatic rise in unemployment that has dramatically increased the scale of bad debts.

A report by Spain's central bank spooked the markets last week after it revealed that the amount of bad loans on the books of Spanish banks has risen to an 18-year high of 8.15% in February and accounted for €143.8bn (£117.7bn) of their outstanding €1.76tn of loans.

Spanish banks were one of the chief beneficiaries of the European Central Bank's €350bn loan scheme to rescue the eurozone's weakest banks.

Much of the money borrowed by eurozone banks has been lent to governments and been used as short-term financing to replace funds usually provided by private investors. Spanish banks own around €200bn of Spanish sovereign debt.

So far, the struggling rightwing administration of Mariano Rajoy has dismissed concerns that Madrid could be forced to plead for funds from Brussels, despite wrestling with declining tax receipts and conflicts with regional government that are seeking to block spending cuts.

The Madrid stock market has fallen more than 15% in recent months amid concerns that Rajoy is being forced to adopt further austerity measures that will hurt the economy and worsen unemployment.

The economy is expected to shrink by as much as 2.7% this year, and there is precious little prospect of growth if the government is forced to raise taxes to meet this year's 5.3% deficit goal and the target of 3% in 2013.

In a desperate bid to fill the exchequer's coffers, Rajoy recently announced a tax amnesty that he expects to top €25bn, generating a meagre €2.5bn in receipts.

The ECB added to concern that Europe's banking sector is increasingly prone to collapse after it called on authorities to set up a body to manage bank rescues in the eurozone. The message marked the bank's strongest intervention yet in the debate on whether the costs of bailing out troubled banks should be shared.

The ECB said there were 36 banks vulnerable to collapse across the currency zone. "The case for strengthening banking supervision and resolution at a euro-area level has become much clearer [as a result of the crisis]," ECB president Mario Draghi said. "Work on this would be most helpful at the current juncture."